Up 7% over the past month, the Financial Select Sector SPDR (NYSEArca: XLF), the largest financial sector ETF, looks sturdy ahead of spate of third-quarter earnings reports due out this week and next week from major banks.
Some strategists also argue that the financial sector may be a good area to look at this time around, given the potential for growth in a rising rate environment, along with potential tax and regulatory changes under the Donald Trump administration. After failing on the healthcare front, Congressional Republicans are likely to push forward with tax reform, looking to make that the centerpiece of their 2017 legislative accomplishments.
Rising interest rate expectations are also fueling a rally in XLF and rival financial services funds.
XLF “has moved higher in tandem with expectations for a third rate hike in 2017, with the CME Group’s FedWatch tool now predicting an 86.7% chance that the U.S. central bank will lift its benchmark rate by 25 basis points at the December meeting,” according to Schaeffer’s Investment Research.
As conditions improve, the Federal Reserve will tighten its monetary policy to obviate an overheating economy. The central bank has already outlined plans to start winding down its trillion dollar balance sheet in October and left a December rate hike open. Investors should anticipate a tighter policy as a key inflation gauge this week could confirm U.S. inflation is moving toward the Fed’s 2% target.
Looking ahead, analysts project U.S. bank earnings to expand 12.8% in 2018, and BlackRock sees “scope for this number to improve.” Furthermore, the sector is trading at cheap valuations, with U.S. banks discounted by24% compared to 5% for European banks.
“XLF just wrapped up its fourth consecutive weekly gain — which represents the fund’s longest such streak since late January/early February — and on Friday touched its highest point since the financial crisis, peaking at $26.46,” notes Schaeffer’s.
Although the Fed has raised interest rates twice this year with another rate hike likely coming before the end of 2017, there are concerns about the central bank’s dovish tone and its impact on ETFs such as XLF. It is expected the Fed will boost borrowing costs one more time before the end of this year and that as many as three rate hikes could be on tap for 2018.
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